The 25 Highest-Yielding REITs in March

Dividend investing is popular again. Investors have taken to heart Jeremy Siegel's studies, which show that higher-yielding stocks tend to offer greater returns over time than low- or no-yield stocks do.

The highest dividend yields can be very tantalizing. As long as a stock yielding 15% doesn't lose value, you'll make 15% in one year! In more cases than not, however, an astronomical yield is a bad sign for a stock. Since dividend yields and stock prices move in opposite directions, a high yield usually means investors have begun to worry about the business and driven down its stock price.

Most real estate companies are organized as real estate investment trusts, or REITs. They do this so that they can get around the double taxation issue that most investors face. REITs don't pay taxes as long as they distribute at least 90% of their income as dividends. The investor holding shares of the REIT then has to pay taxes on those dividends as though they're income. That differs from most dividends, which are taxed at a lower rate.

Dividends aren't guaranteed; you need to make sure a business is generating enough cash to pay its dividend, or your investment could be disastrous. So I ran a screen for the highest-yielding REITs, and the only limitation I set is they must have a market cap greater than $1 billion.

These stocks are a good place to start your research, but they're not formal recommendations.

Let's take a close look at the top four.

1. First up is American Capital Agency, with a trailing yield of 15.1%. American Capital Agency is a mortgage REIT, or mREIT, which invests only in securities backed by the U.S. government. These REITs borrow money and use it to buy higher-yielding mortgage-backed securities, earning the spread between the mortgage-backed securities and the cost of borrowing. The Federal Reserve has been buying up billions of mortgage-backed securities every month in an effort to push down mortgage rates. Mortgage REITs have seen the spread they earn on their mortgage-backed securities decline, as these purchases have had a major effect. mREITs have followed different strategies to cope with the declining spread.

American Capital Agency's strategy, like its cousin American Capital Mortgage, is run by CIO Gary Kain. Last year before the Fed announced its third round of quantitative easing, Kain laid out the company's strategy, which expected that QE3 would happen and that the Treasury Department would buy up mortgage-backed securities, pushing down rates and boosting refinancings. To protect itself, the mREIT bought mortgage-backed securities with low loan balances and those that had previously been refinanced, lessening the risk of prepayment. QE3 did indeed happen, and American Capital Agency profited from its strategy.

The company recently did a secondary offering of 50 million new shares at a little over $30 per share. While some analysts were worried that the secondary offering would dilute existing shareholders, the offering comes at a time when American Capital Agency has been able to take advantage of the dollar roll market to keep its interest-rate spread wider than those of its competitors. As of the end of the fourth quarter, the company now has a leverage level of 7 and an interest-rate spread of 1.39%. While insiders are buying shares, investors in American Capital Agency should be confident in the company's strategy and the risks that a continued QE3 or a rise in interest rates present going forward.

2. Second up is ARMOUR Residential REIT, with a trailing yield of 14.20%. ARMOUR invests in hybrid adjustable-rate, adjustable-rate, and fixed-rate residential mortgage-backed securities that are backed by the U.S. government. As of the end of February, the company now has a leverage level of 9 and an interest rate spread of 1.39%. ARMOUR has been challenged recently by QE3, with the company's constant prepayment rate rising to an annualized high of 19.1% in January, though it has since come back down to 11.1%.

ARMOUR holds roughly $2 billion in adjustable-rate mortgages and the rest in fixed-rate securities. The company has hedged almost 40% of its portfolio's interest-rate exposure. As long as QE3 continues, ARMOUR's interest-rate spread is likely to continue to decline, which will probably mean a falling dividend.

3. Third is American Capital Mortgage Investment, with a trailing yield of 13.7%. American Capital Mortgage follows the same strategy as its cousin American Capital Agency, but it invests in both agency-backed and non-agency-backed securities, while American Capital Agency is restricted to government-backed securities. As of the fourth quarter, the company has a leverage level of 6.7 and an interest-rate spread of 1.88%.

4. And finally, we have Annaly Capital Management, with a trailing yield of 13.3%. Annaly invested solely in agency mortgage-backed securities, though that has changed with the company's acquisition of Crexus, its cousin that invests in commercial real estate. Annaly's CEO has said that after the acquisition it will invest up to 25% of its equity in real estate assets other than agency mortgage-backed securities.

QE3 has been a challenge this year for Annaly, with a high constant prepayment rate of 19% and a steadily declining interest-rate spread, which was most recently at 0.95%, a hefty drop from last year's 1.71%. With the declining spread, analysts and investors turned on the stock and sold it off to below book value. Annaly took advantage of the drop in its share price and bought back 27.8 million shares in the fourth quarter at an average price of $14.28.

While Annaly faces multiplerisks going forward, with a new strategy set to take effect, it will be interesting to watch what happens.

Foolish bottom lineRemember, these REITs' seemingly irresistible yields could be ticking time bombs, so do your own due diligence. Also make sure you diversify your picks across various sectors. As investors relearn every decade or so, you never want to put all your eggs in one basket -- no matter how tempting the dividends are.

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